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Novartis Posts a Swiss Miss

Novartis has a strong pipeline, but moderate growth and high valuation suggest little room for error.

Befitting the uncertain outlook that many investors have for the drug sector, Swiss drug giant Novartis(NYSE:NVS) reported mixed results on Thursday morning. Although sales were up 13% in dollars (and 8% in local currency), net income for the quarter was up only about 1% and operating income was actually down over the prior year. Consequently, Novartis missed analysts' estimate of $0.60 a share in earnings and posted $0.57 instead.

Though sales of drugs like Diovan, Gleevec, Lotral, and Lamisil remain strong, they couldn't do it all by themselves. Like most pharmaceutical companies, Novartis is dealing with a knock-down, drag-out fight from generic competitors. To that end, the company is spending more on promotional activities and some of that extra expense is hitting the bottom line.

Interestingly, Novartis management devoted a fair bit of time on the conference call to discussing the state of the generics industry. In particular, management believes that the generics industry is entering into a cyclical decline as numerous new generics are hitting the market and pressuring prices. This isn't exactly news to Wall Street, though, as investors sold off big generics names like Andrx(NASDAQ:ADRX), MylanLabs(NYSE:MYL), and Teva(NASDAQ:TEVA) in the second half of 2004. While this could be bad for big pharma in the short run as lower prices will hit revenues and margins, it may hint that the worst is almost over.

As Pfizer(NYSE:PFE)did yesterday, Novartis devoted a considerable amount of energy to the strength of its R&D pipeline. The company has 52 products in clinical trials or registration and expects to file for approval for at least five drugs in 2005. Better yet, six of the products in late-stage development are first-in-class drugs. With drug candidates like an oral formulation for multiple sclerosis and a promising new type of oral diabetes medicine, patient shareholders do have reason for optimism.

Unlike Pfizer, Novartis shares aren't necessarily a clear-cut value. The stock trades at a healthy 21 times 2004 earnings and an EV/FCF ratio of 20 -- a number that is well above both its return on equity of 18% and its long-term growth estimate of about 12.5%. Although Novartis' pipeline is well-stocked with promising candidates, these shares never took quite the same pounding as other large-cap pharmaceuticals and actually were up a bit for the year.

Though drug stocks in general may be too cheap, Novartis looks like a stock akin to one of the fine Swiss watches of its homeland -- very high quality, but at a high cost.

Fool contributor Stephen Simpson holds a CFA and has no ownership interest in any stocks mentioned.